Factor-Based ETFs Provide Increased Stability, Returns

| About: iShares Edge (MTUM)

Summary

Factor-based investing is the right investing strategy for this market climate.

MSCI Diversified Indices returned better than regular ETFs.

Diversified indices consistently optimize to meet target exposures to certain factors.

During a volatile market climate where ETFs are especially getting hit hard, an increased utilization of factor-based investing has the opportunity to provide more stable and higher returns. Factor-based investing allows investors to increase exposure to certain factors, including size, value, quality and momentum.

Last year, MSCI introduced a variety of multi-factor indexes that offer investors a better strategy that could be just right for this market environment. These indices cover US, World, Emerging Markets, and more.

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The 1 year return of the MSCI US Momentum Index (NYSEARCA: MTUM) distinctly outperformed iShares Russell 1000 Value ETF:

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(Source: Bloomberg)

A Focus on Momentum

Momentum-based investing has proven to be a successful strategy in a volatile market climate, as seen with AQR's posted returns in their liquid alternative funds. Such a strategy can provide returns in a downed market as well because the strategy works both ways. A hedge fund can short a portfolio of negative momentum securities and vice versa.

For MSCI with their new diversified multi-factor indices, it's all about choosing the right exposure to multiple factors, not just momentum. They're targeting four main factors (listed above), including momentum. The MSCI USA Momentum Index didn't perform well in the past year (-8.04%), but the MSCI diversified multi-factor indices have seen much better returns. MSCI is able to increase or decrease their exposure to certain factors that they see as favorable or unfavorable. Such optimization is extremely strategic as risk level of the underlying index is maintained.

These multi-factor indices aren't brand new strategies, either. The MSCI World Diversified Index returned an annualized 9.8% over a 16-year period during backtests, which is double the return of the regular MSCI World Index. The main methodology is to increase factor exposures to achieve higher historical returns.

Which Factor is the Best?

With the recent sell-off and market environment that is arguably a mess, what is the right factor to increase exposure to? With the MSCI World DMF index, which has one tilt towards value, there was a positive exposure to earnings yield even in this market. There is no one best factor, which is the point of these indices. A combination of multiple positive exposures with tilts towards different factors (momentum, size, value, quality, leverage, etc.) is what has made these MSCI products produce better returns than the run-of-the-mill ETFs. For example, the MSCI World DMF Index had positive exposure to stocks of lightly levered companies, lower residual volatility and smaller size:

(SOURCE: MSCI)

The above described strategies for ETFs is something investors should make note of as clearly alternative strategies are needed in this market situation. Consistent optimization of diversified multi-factor products, like those of MSCI's, are not completely immune to risk, but have now proven to have broken away from the poor performance of regular ETFs in the past year. Factor-based investing is very optimal for this market is a very forward-thinking investing strategy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.